How Much Financial Inequality Is Due to Financial Illiteracy?

Annamaria Lusardi, whose ground-breaking research on financial literacy has been featured here several times, has put out a new working paper (with co-authors Pierre-Carl Michaud and Olivia S. Mitchell) that could be read as laying much of the blame for the lack of household wealth at the foot of the members of said household. The paper is called “Optimal Financial Knowledge and Wealth Inequality” (abstract; PDF):

While financial knowledge is strongly positively related to household wealth, there is also considerable cross-sectional variation in both financial knowledge and net asset levels.  To explore these patterns, we develop a calibrated stochastic life cycle model featuring endogenous financial knowledge accumulation.  The model generates substantial wealth inequality, over and above that of standard life cycle models; this is because higher earners typically have more hump-shaped labor income profiles and lower retirement benefits which, when interacted with precautionary saving motives, boost their need for private wealth accumulation and thus financial knowledge.

Our simulations show that endogenous financial knowledge accumulation has the potential to account for a large proportion of wealth inequality.  The fraction of the population which is rationally financially “ignorant” depends on the generosity of the retirement system and the level of means-tested benefits. Educational efforts to enhance financial savvy early in the life cycle so as to produce one percentage point excess return per year would be valued highly by people in all educational groups.

Not to get all self-referential, but one good way to “enhance financial savvy early in the life cycle” might be to let people know that it is a bad idea to consistently invest your income in a scheme whose expected value is about -40% (yes, I’m talking about the lottery, again!). That is of course not so easy when the lotteries are run by states who see them as profit centers.

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  1. Eric M. Jones says:

    Hidden due to low comment rating. Click here to see.

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  2. Seminymous Coward says:

    I’m sure the intent of the researchers is neutral or perhaps even positive, but it’s quite difficult not to be upset by the content.

    That lack of education keeps poor people poor is a refrain echoing across history, whether it be literacy, numeracy, or its financial equivalent. Even the modern poor have unacceptable levels of the first two, as their schools fail to achieve even baseline standards; those standards don’t even touch on finance, personal or otherwise. It’d be hard to hear a finance teacher above the cacophony of advertisements and quasi-advertisements for usurious credit and extravagant lifestyles (via products with profit margins to match), anyway, I suppose.

    That they tested for whether cutting retirement benefits would boost financial literacy is just a bitter icing for this poison cake. I can hear the chorus of “The poor are only poor out of ignorance; cut those pensions so they’ll smarten up and pull themselves up to the top by their bootstraps!” At least there’s no echo on that one, as historically the rich have felt little need to pretend.

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    • Seminymous Coward says:

      Just to close on a less embittered note, the retirement benefits portion of the research is almost eerily reminiscent of the “kill all the poor” skit from That Mitchell and Webb Look.

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    • James says:

      Suppose, though, that the reason this refrain keeps echoing across history is that, however bitter you may find it, it is truth. (Perhaps not the whole truth in all times and places, but still truth.) The world doesn’t come with any guarantee that the truth is always going to be comfortable.

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      • Seminymous Coward says:

        I apologize for the lack of clarity; I agree that a lack of education, whether explicitly intentional (even legally enforced) or not, is a prime cause for the poor staying poor. Education has a utility bordering on the magical, at least in times and places where it can be leveraged, which mercifully includes the modern developed world. My second paragraph was merely lamenting the maintenance of low to no educational standards in the schools accessible to the poor. I don’t dispute that conclusion; it just upsets me.

        I also wholeheartedly agree that hard truths are still truths. Accepting the veracity of an implication shouldn’t mean considering its consequent immutable, though; it only means that the antecedent must be the point of attack.

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    • pawnman says:

      I’m not sure the idea is so much that we SHOULD cut retirement and other benefits, but that when people depend on others to take care of them in such a fashion, they have less incentive to learn how to manage their own financial well-being.

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  3. Laura Conrad says:

    I live in Massachusetts, where a lot of the state’s profits from the lottery go to the schools. I’ve always thought that a condition for a school getting that money should be that it include probability and expected winnings in its mathematics curriculum.

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  4. Michael J. Foley says:

    I think the bottom line here is that a little education about saving for retirement goes a long way. Think of this more as teaching our kids the value of first putting a % of their earnings in the bank first before they go out and spend it on the latest “need”. This is a hard lesson to teach and learn, but one that is vitally important so that we do not become completely dependent on the government for our end of life care and well being. Social Security was never meant to replace our own savings, but to supplement them. Too many of us have forgotten that message and we have forgotten the power of compounded interest over time (the PERT formula).

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  5. Bill Ogorodny says:

    I do not know why there are not more classes in finance in the high schools. Young people should learn about investing and saving for retirement. They should also learn about debt and the tremendous costs of getting behind on your credit cards.

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    • BradK says:

      Personal finance should be taught to children from the time they’re mathematically able to understand even basic concepts all the way through secondary education. Yet, we still need to find a way to make the subject “sexier” for easier digestion. Same with entrepreneurship. Learning to monetize any skill and bring it to market successfully is a critical skill regardless of an individual’s interests and eventual vocation.

      Regardless, we’re always reduced to the fundamental problem of, “How do you develop healthy/successful habituation in children if they’re stuck in a world where their role models only exemplify unhealthy/unsuccessful patterns?” Specific to this issue, if all adults around a particular child have bad financial habits, you can lecture in school about the proper way to do things all you want, but that child will still probably end up as an adult with bad financial habits.

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      • Enter your name... says:

        I think that last point is critical. If your first paycheck comes with parents asking questions about how you invested your retirement savings and offers to help you get started, you’ll do better than if your first paycheck comes with parents asking what treat you’ll buy yourself at the mall or which bar you’re going to to celebrate or if they could “borrow” some because they’re short again.

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    • Seminymous Coward says:

      Ask yourself who decides on the required curriculum and who decides to keep school budgets and overhead at such a level as to threaten even the more popular optional offerings like art & music, taking the steam out of any push to add other options, like finance.

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    • pawnman says:

      It can start at home, prior to high school. Once your kids learn that money can buy things, you can give them an allowance for doing chores. Then, give them a choice: the allowance in cash now, or put it into a bank account where you will match their contribution dollar-for-dollar (giving them an incentive to delay gratification). Once you get them into the habit of saving money, they’ll be more likely to continue the trend into the future.

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  6. Sooze says:

    Speaking of lotteries as school funding, a lot of money seems to be raised that way…why are schools still suffering?

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    • Derffie says:

      The amount of monies provided by the lottery is in the single digits percentage of the education costs.

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      • Enter your name... says:

        And the little bit that the lottery provides has been matched by reductions from other funding sources. The funding boost only lasts for a couple of years, and after that, legislators start saying, “Well, we’ll only reduce our contribution a little bit. After all, they have all this other money from the lottery, and things are really tight for us…”.

        This is true in general. It happens to schools with lottery money, breast cancer research with semipostal stamp money, and every other consistent, predictable source of “extra” money. If you wanted to stop this phenomenon, you either have to rotate (lottery money pays for schools this year, preschools next year, dentists for little kids the fourth year, then back to schools) or make the money exclusively for something that isn’t being done yet (lottery money buys “free, drop-in, after-school tutoring for poor schools” or “solar panels for schools” or [in California] “free school bus service”).

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    • Jim says:

      The “Lottery supports education” is just a shell game. Do you honestly think that once lottery money is coming in to the school budgets that the legislature doesn’t cut “general fund” moneys from the school in equal (or greater) amounts?

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      • A concerned parent says:

        A group of Florida economists proved this out not long after Florida implemented a lottery that was sold as “augmenting educational budgets”. Instead, they found that lottery money simply sustained educational budgets.

        Obligatory reference:

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      • econobiker says:

        State run lotteries were established to take those profits away from organized crime i.e.: the numbers racket and get the ability to tax gambling profits.

        Given that New York was the first state to establish a lottery, this money grab makes complete sense.

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    • Joe J says:

      Because the quick easy answer of throw money at it, makes the problem worse. There is good evidence that the more money spent on a school the worse it becomes. DC pubic schools are someof the worst in the country they are also the ones with the highest per student amounts spent.

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  7. Julie says:

    Of course, the flip side is that the more wealth/income you have, the more incentives you have to be financially literate. If you’re barely making enough to pay rent, it doesn’t really matter whether you understand the different financial vehicles on the market; you’re never going to use them. It doesn’t matter if it makes more financial sense to buy things in bulk if buying one product in bulk means slashing your grocery budget in half for a week.

    An interesting article from Cracked on this topic:

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  8. TexCIS says:

    Schools make time to teach “green concepts” like recycling, wind power and solar, where the cost/benefit ration is negative. They have time to take children on “field trips” to teacher strikes to learn about politics (protest for the unions) . . . isn’t that largely about benefits and “financial incentives?”

    Schools could make time to teach finance if they wanted to. It could be worked into the math curriculum in the form or word problems, like:

    If Mary works for $300 per week, but she spends $400 per week . . .
    A. Will she have more in her savings account or on her credit card bill? ____________
    B. Will that number be positive or negative? __________

    If Mohammed saves $50 per month for 25 years
    A. How much money will he have in savings? ___________
    B. How much would he have if he earned 3% in interest at the bank? ____________
    C. How much wold he have if he earned an average of 6% in index funds in the stock market? _____
    D. How much would that money buy if he earned 3% in interest but inflation was 5% per year.

    There. No extra time spent. Finance taught.

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    • Seminymous Coward says:

      Only 2B and 2C are well-formed. There’s a false dichotomy of where money can be in 1A. 1B is ambiguous regarding which number is being discussed. 2A doesn’t indicate which definition of savings you mean or where the money he saves is stored. 2D utterly fails to ask for value in present-day dollars, though your intent could be divined. In fact, 2B and 2C are only well-formed until 2D raises a question as which year’s dollars you meant in the previous questions. It’s almost like teaching was nontrivial.

      You also failed entirely to account for the time to define your terms and draw non-numeric conclusions. Concepts like declining marginal utility, economies of scale, and temporal discounting are vital, but, even as a mathematician, I must admit that the raw numeric behavior is not enlightening in the absence of proper interpretation. Legal, regulatory, and actuarial issues are also important considerations in financial planning.

      The sad truth, though, is that your suggestion would still be better than what most students get, even exactly as you’ve presented it.

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      • TexCIS says:

        I’m talking public school math, not college. Even college students don’t learn about “declining marginal utility” unless they take an economics class, nor about “economies of scale” unless they take a business class.

        Your points are well taken. The questions should state that Mary starts out with zero dollars in her savings and in her credit card balances. Then 1A and 1B stand.

        On question 2A it doesn’t matter where the money is saved, the question defines the interest rate as 3%. But you are correct, the rate should be defined as simple or compound. We should drop questions 2C and 2D as being to complex for today’s public high school students, and many of their teachers as well.

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